Why we should all keep an eye on gold prices

Two memorable pieces of financial news came last week. We had the revelation of secret short-term loans by the Bank of England to Lloyds and RBS to keep the cash machines working.

Then we had Dubai's debts - perhaps more an inevitability than a shock, though it was hard to resist a jeer at HSBC, a major lender there. 'We never underestimate the importance of local knowledge' as the bank says (still) in its TV advertisements.

No shocks so far this week. But then, it's only Wednesday.

Debt-ridden: news of Dubai's debt was no real shock

Perhaps we shall have no shocks until next week's pre-Budget Report, when Chancellor Alistair Darling will take a Valium or two and summarise our debts.

He will no doubt point out that other countries have grim debts, too (though very few are quite on our scale).

But here's a funny thing about the global financial scene. The received wisdom of the Government and most commentators is that we must worry about deflation - low or negative inflation, rising unemployment and poor growth. We must not repeat the Japanese experience, runs the cry.

Yet the price of gold - the classic hedge against inflation - has been going through the roof. Apparently armies of investors are gambling that inflation will be the big problem, if not now then soon.

This may seem odd. Yet it may not be so illogical. History reminds us that when governments have mountainous debts, especially after wars, they often resort to inflation as a means of dodging their creditors.

It enables governments to pay off their liabilities in money which has lost much of its buying power.

Don't think that we are guiltless in this. After World War II, the then government launched a major issue of stock at 2.5 pc interest, known as Daltons after the Chancellor of the day. Inflation was allowed to creep up and the cost of repayment fell steadily. The holders of these bonds, or 'gilts', were effectively wiped out.

Other governments during the last century deployed the inflation weapon massively.

Most famously, Germany after World War I initiated a hyperinflation which eventually led to the issue of trillion mark notes.

Austria's inflation at that time soared above 1,000pc a year. Hungary broke all records after Word War II, by issuing a 100 billion pengo note. More recently, Poland allowed inflation after the collapse of Communism, which left the exchange rate at $1 = 2 million zloty!

The list of countries that allowed hyperinflation is very long. Britain has never allowed that - only superinflation. In 1975 the rate reached 25pc before our finances were returned to order by Denis Healey's stern budgets.

The mechanism for allowing inflation is relatively simple: the authorities just print more money. Plentiful credit stimulates the economy, encourages spending and helps employment - for a while.

During our big inflation period, the basic, government-controlled cause of inflation was denied. Both Tory and Labour governments blamed it on irresponsible rises in prices and wages. It was rather like assuming wet pavements cause rain.

In the light of history, we can see the reason some investors are so keen on gold. There are mountains of debt over the world. The cost of repayment will be massive. What is to stop governments resorting to the old ploy of inflating their way out of repayment?

In our case, the mechanism has been put in place. Printing money is called quantitative easing - a delicious euphemism - and the Bank of England has been at it for some time and on a serious scale.

In theory, the strategy works something like this. The Bank provides easy credit to the commercial

banks, which will be encouraged to lend to business and individuals and get us out of recession.

But if that results in inflation on any serious scale, the Bank will fling all the engines into reverse and curb the supply of money.

One catch about this is that it takes a long time before a rising money supply shows up in rising prices. Another is that inflation is hard to control once it gets a grip. Yet another is that retaining a low inflation target - still required of the Bank - and simultaneously pumping money into the economy has never been tried before.

It is like driving with both feet pressed down hard on the brake and the accelerator. The situation is not much better in the U.S.

Hyper-inflation is unthinkable in Britain. But a spot of Seventies-style inflation at some point is not. The message in the gold price is that governments should not be trusted. As a general proposition, it is hard to disagree.